Fixed Income

EMD Relative weekly notes

Week Ending June 2, 2017

06/05/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This week two large asset management firms were noted by the press to be purchasing debt "directly" (via an intermediary but in most senses directly) from the Venezuelan government at fire sale prices. Any spotlight on the wobbling Venezuelan situation and the dynamic it is producing in the EMD market is welcome to us. The most interesting implications are those least highlighted.

--The press stories focus on the opposition's contention that the firms were funding a corrupt regime. Indeed, in this sense there is a difference between purchasing bonds in the secondary market from other investors and providing fresh cash to the government. The inflow to the government was achieved by paying a princely sum of 42% interest. No rational investor would recognize that as anything but very temporarily sustainable.

--Investors achieving such implicit returns surely hope to sell the bonds on to other investors at a quick profit, since they trade well below secondary market prices. Widespread recognition of the transaction, as well as a Venezuelan opposition party suggestion they will not honor the debt should they take power doesn't help the cause for thee investors.

--Secondarily, the best that investors hope for is a regime change and a benign restructuring that causes bond prices to soar from current levels. Here is where it gets interesting: providing fresh cash encourages a government already incentivized to personally profit from gross economic distortions to continue along their current path ever farther upon the assumption that others might finance them similarly in the future--even if things are not sustainable to nearly any observer. Should this insight be true, they will run down the ever fewer remaining assets closer to zero while incurring additional liabilities. That will leave any eventual restructuring that much more difficult to achieve and less attractive, in our opinion. Therefore, theese investors are very possibly reducing the probability of the benign restructuring they hope will bring them riches.

--We own no Venezuela, but we understand the impulse. Bonds in the secondary market yield about four times other non-investment grade EM debt. Investors hold the bonds in the belief that looking at the payment schedule of the country and when large payments are due, offers a reliable barometer of when to worry about default. There is literally no other data available. However, anecdotal signs beyond the daily protests are available: tankers wait offshore to unload in Venezuela for weeks awaiting payment, refineries operate at less than 50% capacity consistently, and yellow corn, the basic ingredient of the most basic food staple in the country, has apparently run out with the next shipment expected in about 10 days.

Given those types of stress, we think a break at any moment in the delicate chain of events in an unforecastable way seems highly possible, if not probable. Additionally, passive inflows into the asset class are propping up bond prices and removing any price signal of increasing distress which enhances investor complacency. All of this, in our view, seems a formula for disappointment for those wagering client money in Venezuela.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.